By John Galt
December 05, 2011 – 12:20 ET
A fascinating speech from the Federal Reserve Bank of Chicago’s President Charles Evans was delivered today and just released via the Fed website:
To read the speech in full, click on the link above.
Two fascinating statements from the speech caught my attention and should signal that there is a level of deep concern within the Fed hierarchy that is not being discussed by the financial media. First the idea that the U.S. economy and Fed policy is mired in a liquidity-trap:
There is a second competing storyline — one that I refer to as the “liquidity trap scenario.” First, consider what occurs during normal times when nominal rates of interest are considerably above zero and real rates of interest are positive. If the supply of savings increased but the demand for investment remained unchanged, market forces would drive down real interest rates to some natural rate of interest that equilibrates savings and investment. This market dynamic is thwarted in the case of a liquidity trap.
Here, cautious behavior holding back spending — whether it is due to risk aversion, extreme patience or deleveraging — causes the supply of savings to exceed the demand for investment even at very low interest rates. Today short-term, risk-free interest rates are close to zero and actual real rates are only modestly negative. But they are still not low enough — because short-term nominal interest rates cannot fall below zero, real rates cannot become negative enough to equilibrate savings and investment.
As I weigh the evidence, I find the case for the liquidity trap scenario more compelling than one for the structural impediments scenario. My assessment has been influenced by the book titled This Time Is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff. Reinhart and Rogoff document the substantially detrimental effects that financial crises typically impose on the subsequent economic recovery. As we all know, the recent recession was accompanied by a large financial crisis. When I look at the U.S. economy today, I see it tracking Reinhart and Rogoff’s observation that such recoveries are usually painfully slow — and are so for reasons that have little to do with structural impediments in the labor market and the like.
Liquidity traps are rare and difficult events to manage. They present a clear and present danger that we risk repeating the experience of the U.S. in the 1930s or that of Japan over the past 20 years. However, liquidity traps have been studied over the years in rigorous analytical models by a number of prominent economists, including Paul Krugman, Gauti Eggertsson, Michael Woodford and Ivan Werning. Variants of these models have successfully explained business cycle developments in the United States. The lesson drawn from this literature is that the performance of economies stuck in a liquidity trap can be vastly improved by lowering real interest rates and lifting economic activity using an appropriately prolonged and forward-looking period of accommodative monetary policy. Of course, such monetary accommodation is the antithesis of the policy prescription for the structural impediments scenario.
This is an indication that at least some members of the Fed have finally begun ot realize that the U.S. economic dilemma extends far beyond the financial sector and is indeed a structural problem requiring the complete deleveraging of the consumer and businesses to adjust to a reduced level of economic expansion if not more sudden and frequent periods of contraction.
The second excerpt is an even bigger eye opener:
Today, I have outlined an appropriate course for monetary policy to take when we cannot know with certainty the degrees to which various forces are driving the economic weakness we currently face. If, as I fear, the liquidity trap scenario describes the present environment, we risk being mired in recession-like circumstances for an unacceptably long period. Indeed, each passing month of stagnation represents real economic losses that are borne by all. In addition, I worry that even when the economy does regain traction, its new potential growth path will be permanently impaired. The skills of the long-term unemployed may atrophy and incentives for workers to invest in acquiring new skills may be diminished. Similarly, businesses facing uncertain demand are less inclined to invest in new productive capacity and technologies. All of these factors may permanently lower the path of potential output.
Thus the idea that some members of the blogosphere and elsewhere, like myself, that we are still mired in a prolonged period of sub-standard economic growth with systemically high unemployment and little prospect of a full recovery to pre-2007 economic levels seems to be validated somewhat by the Fed’s Evans. Unfortunately, all of the proposed solutions involve the epic blunder of monetary expansionism along with massive government intervention which does nothing but to impede business and slow growth. Stay tuned as this is beginning to sound more and more like the laying of the foundation to justify a new QE program in early 2012.